Retirement seems like a long way off. Nothing but a destination far off in the distance that has little consequence for us in the here and now.
That’s future us’ problem, right?
Unfortunately, not. We’ve talked before about the many advantages of starting to save young.
Planning for retirement is the same thing. It’s a wave best caught early, otherwise you spend the rest of your life paddling frantically to catch up.
Today we’re talking about a little government program developed in the 50s called retirement savings plans or RRSPs.
We’re going to cover everything from what they are and who can contribute to them, to some common myths about RRSPs, and some legitimate concerns about them.
This article has two goals: One is to provide you with enough information that you can feel confident talking about RRSPs. The second goal is to help you make an informed decision as to whether or not an RRSP makes sense for your particular financial situation.
What is an RRSP?
An RRSP is a legally recognized trust with the federal government. It is not an investment itself. It is a special type of investment account where you can hold savings and other investment assets.
There are many types of investments that can be held in an RRSP. These include, but are not limited to:
- Savings bonds
- Treasury bills (T-bills)
- Bonds (including government bonds, corporate bonds and strip bonds)
- Mutual funds (only RRSP-eligible ones)
- Equities (both Canadian and foreign stocks)
- Canadian mortgages
- Mortgage-backed securities
- Income trusts
- Corporate shares
- Foreign currency
- Labour sponsored funds
What you can’t hold in an RRSP: precious metals, personal property (art, antiques, and gems), or commodity futures contracts. Those are the rules.
Who can get an RRSP?
Just about anyone. If you’ve filed a tax return and have an earned income, you are eligible to join the party.
You can open an RRSP with banks and trust companies, credit unions, mutual fund companies, investment firms, and life insurance companies.
Who can contribute?
You, your spouse, or your common law partner can contribute to it; however, it must be closed when you turn 71. At that time, you can withdraw your RRSP savings in cash, convert them to a registered retirement income fund (RRIF), or buy an annuity.
Why get an RRSP?
RRSPs were introduced in 1957 to supplement registered pension plans and encourage Canadians to save for retirement.
While the intention of the program is to set you up better for retirement, I would say the majority of people get them for the tax benefits they are going to experience in the here and now.
- Your contributions are tax deductible
Your taxable income is reduced by the amount you contribute to your RRSP for that year. In a given tax year, you can contribute as much as 18% of your earned income (to a max of $26,010 dollars).
** If you are a member of a pension plan, this will reduce the amount you can contribute to your RRSP. **
- Earnings are tax-sheltered
Investments within an RRSP can compound without you having to pay taxes on the gains. For the time being anyway.
You do have to pay taxes eventually, but this tends to be in retirement when your income tends to be lower than in you peak earning years.
The one caveat to this is that the funds must stay in the RRSP. In contrast to something like a tax free savings account (TFSA), you will take a tax penalty if you choose to withdraw your RRSP contributions early.
Some unfounded concerns about RRSPs
- You have to pay taxes on your contributions eventually, so what’s the point?
A popular knock against RRSPs, although it shouldn’t be enough to prevent you from contributing to RRSPs altogether.
Since you get a tax reduction upon your contribution, an RRSP provides a completely tax-free rate of return on your net contribution. This holds true if the tax rate is the same in the year of your contribution and the year you make the withdrawal.
If the tax rate is lower in the year of withdrawal, you get an even better after-tax rate of return.
Even if the tax rate is higher in the year of withdrawal, the benefits of compounding tax free wash out the taxes you’ll eventually have to pay.
- Having too much in an RRSP means there will be a huge tax bill when you die.
The rules say that your RRSP is included in income on your terminal tax return with tax payable at your marginal tax rate for the year of death.
If you have a surviving spouse or partner, or you have a financially dependent child or grandchild, a tax-deferred rollover will be granted.
You can also take annual withdrawals from your plan during your lifetime to maximize the income that will be taxed at low rates.
Some genuine concerns about RRSPs
Some financial gurus suggest RRSPs are an outdated program that does not reflect the current job market.
Their primary critique is that the program was developed way back in 1957: a time when long term job security was more prominent and people were much more likely to retire in a lower tax bracket than in their peak working years.
We now live in a gig economy. Job precarity is more common and many Canadians spend much of their careers in various entry-level jobs or spend some of their working years dealing with unemployment.
If there is a risk that you will have to withdraw funds from your RRSP early, it doesn’t make sense to put investments or savings into them. And this seems to be the case for a lot of Canadians: 40% of Canadians withdrew from their RRSPs early in 2017.
If this is the situation you find yourself in, you’re better off saving your money in something like a TFSA, which won’t hit you with the tax penalty an RRSP does for withdrawing.
Sources and further reading